Alternatives cover a wide range of assets that tend to differ in profile from stocks and bonds. Historically, many alternative funds have been closed-ended in structure to account for the fact that alternative assets are often more illiquid than more traditional assets. But the landscape has evolved, with alternative funds that can accommodate more liquidity often being structured as open-ended funds. This is the case for some European Long-Term Investment Funds, or ELTIFs as they are known. The different ways in which alternative funds operate (closed ended or open ended) has an impact on the way in which they report performance. The key question for investors is how to compare the different performance models.
The characteristics of closed-ended and open-ended funds
Closed-ended funds
In the closed-ended structure, investors commit their capital to be invested into the fund during pre-defined periods where the fund is “open” for investment. However, capital is typically not called in full on day one and is instead called over multiple quarters, or years, as investments are identified and capital is deployed (this is known as the investment term). This approach accounts for the lower levels of liquidity and divisibility that alternatives tend to exhibit and provides the investment manager time to source suitable investment opportunities.
Investor capital is held outside of the fund and then “called” down when the investment manager has found an opportunity to invest in. Investors in this structure are committed for the full term of the fund and do not have the option to elect to redeem. Instead, capital is returned as investments are sold during the “harvest” period.
The closed-ended structure also means that returns tend to follow a “J-curve”, where returns appear negative in the early years as capital is invested and then turn positive as value is created and distributions begin. The J-curve is reflected by the cumulative net distributions line in Exhibit 1.
Open-ended funds
The other structure is for the fund to be open-ended, which is the approach taken by some ELTIFs. Open-ended funds accept and invest money at the same time as investors commit it, and investment managers are generally able to return capital on request, or after a predefined “lock-up” period, by maintaining some exposure to more liquid assets, income/capital distributions, and/or new investor commitments. The manager reinvests capital as assets are sold, or as they make distributions, allowing for some compounding of returns over time.
Why does the fund structure impact how performance is reported?
Closed-ended funds that “call” capital or distribute it when assets are sold will typically report their performance via an internal rate of return (IRR) – also called the money weighted return (MWR). This calculation is sensitive to cash flows and is more appropriate for closed-ended funds given the greater level of control that managers have over the timing and magnitude of a fund’s cash flows.
The underlying calculation for IRR involves solving for the discount rate to make the present value of the investment equal to zero. Calculating the IRR can be done by trial and error, or rather less painfully by using software that can calculate it for you.
In contrast, open-ended funds that invest all monies upfront will typically report a time weighted return (TWR). A TWR measures the compound growth rate of a $1 invested over a defined period and is less sensitive to cash flows. This way of measuring performance is more in line with how daily liquid vehicles report on their performance, as it focuses more on the performance of the investment, rather than the timing of cash flows that the investment manager does not have control over.
TWR and IRR are not directly comparable. Comparing performance is less meaningful between funds using the two approaches, and the different metrics can signal very different outcomes for investors. To solve this problem, investors instead can compare net multiples on invested capital (MOICs) over similar time horizons. MOICs are simply the ending value of investments (including any asset sales or distributions), relative to how much was invested over the time period.
To make MOICs of open-ended funds fully comparable to those of closed-end funds, we suggest investors compare open-ended funds that are reinvesting income to diversified, multi-vintage closed-ended programmes that are recycling capital across time periods instead of making distributions.
What does this mean for me?
Ultimately, the most critical consideration is the return on your investment. If you invest $1,000 today, the key question is how much capital you will have accumulated at the conclusion of your investment period – for instance, after a decade. In this respect, despite a TWR typically being a lower number than IRR, the outcome may not be as different as you think.
In fact, the net IRR of a single vintage within a multi-vintage construct is roughly 1.5-1.71 times the net TWR that delivers a similar MOIC in a 10-year horizon. Understanding this nuance is important when investing in private markets and is worth considering when evaluating different funds. The higher number may not always be better.